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«Miklós-Somogyi, Patrícia and Balogh, László Working Paper No. 65 June 2009 b B A M B AMBERG E CONOMIC R ESEARCH GROUP k k* BERG Working Paper ...»

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The relationship between public balance

and inflation in Europe (1999-2007)

Miklós-Somogyi, Patrícia

and Balogh, László

Working Paper No. 65

June 2009











BERG Working Paper Series

on Government and Growth

Bamberg Economic Research Group on Government and Growth Bamberg University Feldkirchenstraße 21 D-96045 Bamberg Telefax: (0951) 863 5547 Telephone: (0951) 863 2547 E-mail: public-finance@uni-bamberg.de http://www.uni-bamberg.de/vwl-fiwi/forschung/berg/ ISBN 978-3-931052-72-0 Reihenherausgeber: BERG Heinz-Dieter Wenzel Redaktion Felix Stübben∗ ∗ felix.stuebben@uni-bamberg.de The relationship between public balance and inflation in Europe (1999-2007) Miklós-Somogyi, Patrícia – Balogh, László Ph.D.

Chair of Economics and Finance University of Kaposvár, Hungary Abstract The study considers some of the factors determining budget balance. In particular, it investigates the relationship between budget balance and inflation. The analysis focuses on European states in the period between 1999 and 2007, and concludes that the relationship between budget balance and inflation is not demonstrable. In the literature, attempts to quantify the relationship between the two factors have faced severe difficulties.

Inflation influences both the revenue side and the expenditure side of the budget, often increasing one and reducing the other at the same time. These effects might balance each other out, leaving the budget balance unchanged.

(budget balance, budget deficit, inflation) Table of contents

1. Introduction

2. Relationship between state of development and budgetary categories

3. Relationship between inflation rate and the rest of the categories

4. Relationship between the factors of public finance

4.1. Expenditure-to-GDP ratio depending on revenue

4.2. Relationship between gross government debt and expenditure

5. Public balance and inflation in Europe between 1997 and 2008

6. Relations between inflation and public balance

6.1. Segmentation

6.2. Regression analysis

6.2.1. Relationship of inflation and budgetary categories

6.2.2. Factors determining public balance

7. Conclusions

8. References

9. Appendix

1. Introduction The objective of our study is to introduce and analyse the development level and government deficit/surplus of European countries and to analyse and define the relation between inflation rate and public balance. These two factors interact; thus, both directions of the relationship can be analysed, that is, the influence of the change in inflation rate on public balance as well as the impact of balance on the inflation rate. Numerous theoretical approaches can be found considering both issues in the relevant literature. We summarise these theories by showing the role inflation plays in determining government revenue and expenditure, and thus the way it affects the budgetary situation. Following the theoretical argumentation, the interrelations of factors defined in the previous will be presented by using various methods in the international comparative analysis of the variables.

In the relevant literature, the usual way of discussing the relation between inflation rate and public balance is the following: if there is a budget deficit, the acceleration of the inflation can be expected; while if the budget has surplus, the inflation slows down.

According to Erdős (1991) it can be stated that deficit does not always result in inflation even if it is covered by issuing money, and even less so if the deficit is covered by borrowings from private sector (the population or companies). Assuming given and stable amount of GDP, the government deficit covered by money-issuing will not influence inflation if it amounts to not greater than the increase of the amount of money that is intended to be spent on consumption by the public sector. Similarly, it will not cause an increase in inflation rate when government buying expenditures are covered by taxes paid by the private sector. The problem, however, is that gradually decreasing amount of deficit can be financed in this way only when inflation accelerates. In case the deficit is intended to be covered by borrowings by the government, this is possible only in limited extent due to the interest rate. There will be no problem if the GDP increases; hence increasing income induces increasing tax revenue; thus the limit of the government deficit is determined by the growth rate of GDP.

In this paper, however, we do not investigate the factors influencing the inflation rate, nor the

way government deficit affects inflation. The current study intends to answer the question:

what effect does the change in inflation have on the government deficit/surplus?

Macroeconomic theory assumes an obvious relation between these two factors. However, although their interaction is evident, it is difficult to quantify. Several foreign and Hungarian researchers – among others Erdős (1997), (1998), (1999) – pointed out that inflation heavily influences government revenue and expenditure. Thus it is interesting to determine what impact it has on public balance. The impact depends on two factors: 1, the interest paid on borrowings, as the nominal interest rate is adjusted to inflation rate, thus net saving on the interests can be achieved by lowering inflation rate1; 2 its impact on the government seigniorage income. Thus, if inflation decreases, the government deficit can be reduced only if the effect of the former factor is greater than that of the second one. It is however not certain that the nominal interest rate on borrowings will promptly change due to the inflation change, nor that the rate of change will be similar to the change of the inflation rate. This greatly depends on the share of the long term fixed-income securities within the financing structure.

Erdős claims base money can be generated in three different ways, on the basis of which he distinguishes between various seigniorage definitions. His final claim is however the Net interest burden decreases the interest to be paid on internal borrowing excluding the bank of issue. This decline cannot be seen in the budget balance after the debt to the bak of issue, because the paid interest on this debt flow back to the budget through the profit of the bank of issue.

following: decreasing inflation leads to decreasing seigniorage-incomes, which in turn worsen public balance. The questions are what savings in net interest expenditures can be expected due to decreasing inflation rate, considering the interests to be paid on domestic borrowings of the government budget excluding central bank debt, and what decrease in the government revenues is due to the loss of part of the seigniorage income. Erdős’s findings are based on the developments in the nineties in Hungary. He found that lowering the inflation rate can result in significant improvement in the budget balance (Erdős, 1997). Thus, the impact of the decrease in interest expenditure is stronger than that of the revenue due to the decreasing seigniorage-income. Starting from this point we examine to what extent inflation may influence the government expenditure, revenue and public balance. It is not easy to answer the question, however, since different countries have varying development status, inflation rate, growth rate, seigniorage-income2, and internal debt, which fundamentally influence the results of the study. Given that countries are at varying stages of development, and that the inflation rate in countries with lower price level the inflation rate is necessarily higher due to the convergence of the real price level, in these countries higher government deficit can be expected according to the theory. The question is whether this claim can be proven by the analysis of the countries involved in the current study.

In their research on the relation of fiscal deficit and inflation, Catao and Terrones (2003) found that in case of countries with higher inflation rate there is an obvious relation between the inflation and government deficit. Our analysis, however, shows no significant relationship, since inflation rates in their study were substantially higher than what we found.

They used data from much longer time series, including 107 countries in their analyses. As we shall later see, inflation was low in tEuropean countries, with correspondingly different budget situation.

The current study thus deals with the relationship between inflation and government budget.

All of our analyses were based on Eurostat data. In order to reveal the relation between variables several regression models were set up aided by Microsoft Office Excel and the econometric software package Gretl. The data sets origin from 1999 to 2007 and cover the EU-27, Iceland, Croatia, Norway and Turkey. The exact sets of data involved in the analysis are indicated in each phase of the analyses, as some data were not available and the software packages made the calculations on the basis of the involved variables.

2. Relationship between state of development and budgetary categories At first, we analyse state of development, budget balance, government expenditure and revenue, and government debt. We use correlation matrix to define the linear relations between the variables (see Appendix); on the basis of this we found that the development status and government debt are uncorrelated; there is weak correlation between the development level and expenditure-to-GDP ratio. Of course this holds only for the examined countries and for the average data from between 2001 and 2007, thus the finding cannot be generalised. Positive and moderate correlations were found between GDP per capita and public balance as well as the expenditure-to-GDP ratio.

Seigniorage income is smaller in developed countries than in less developed ones, which is true for the analysed European countries as well.

Thus, the more developed a country is, the higher its revenue-to-GDP ratio is, therefore the better situation the government budget is in. Figure 1 shows the linear relationship of GDP per capita and public balance,3 while Figure 24 that of development and government revenue.

Linear regression shows that public balance is determined by the development status of the country by 27.68 per cent; if the GDP per capita increases by 10 per cent of PPS, 0.45 percentage point better balance can be expected on average. Luxembourg, as the most developed country5, is an outlier, while the similarly highly developed Norway poorly fits the regression model due to its outstanding government surplus. The budgetary situation of Bulgaria, Estonia and Finland is better than it could be expected on the basis of their development status; because they can be found much higher than the regression values.

Compared to their development status, Turkey, Hungary and Greece have worse budgetary situation.

–  –  –

Source: Own construction based on Eurostat data sets According to the results, the more developed a country is, the higher is its revenue. On the basis of the regression model, if GDP per capita increases by 1 per cent, the revenue-to-GDP ratio will grow by 0.196 per cent in general. The Figure indicates that Scandinavian states (Finland, Sweden, Denmark, Norway) and France, Belgium and Austria have much higher revenues than that it could be expected according to their development level. According to the regression model a GDP-to-revenue ratio of approximately 45 per cent would be reasonable, considering the data of similarly developed countries (Cyprus, Italy, Germany, Iceland).

Compared to its outstanding development, Luxembourg, as well as Ireland, has much lower The calculation was based on the average data of the EU27, Croatia, Turkey and Norway between 2001 and 2007.

The calculation was based on the average data of the EU27, Iceland and Norway between 2001 and 2007.

Development is indicated by GDP per capita.

government revenue than the regression value would indicate. The GDP-to-revenue ratio of the rest of the countries fits the regression model. It is important to note that the data of Hungary also fits the model, thus the government revenue of the country amounts to what can be expected on the basis of its development stage.

Figure 2: Total government revenue in per cent of GDP depending on development status

–  –  –

3. Relationship between inflation rate and the rest of the categories The regression analysis of development and inflation rate showed moderate negative relationship. It is interesting to find such a definite correlation, because in my previous studies the regional inflation analysis of Italy gave not such obvious results; it seemed that there is no relationship between the development and inflation (Somogyi, 2006). I had two hypotheses

with opposite directions concerning inflation:

• If a region/country is less developed and we assume price convergence across the countries, the lower price level of the less developed region/country may generate higher inflation in the course of the convergence.

• In those – more developed – regions where the consumption expenditure is high, the inflation rates are likely to be higher due to the demand effect; while where the consumption expenditure is lower, the inflation rate can be lower due to the lack of demand.

Assuming these hypotheses the relationship of the two variables was not obvious in the above mentioned cases, however the definite negative correlation coefficient obtained for the EU countries allows us to conclude that the first effect is stronger than the second one; that is, due to the Balassa-Samuelson effect the less developed regions have higher inflation rate.

The analysis of the regression indicated that the best fitting regression model was the multiplicative regression model; the coefficient of determination was (R2) 46.91 per cent, that is the GDP per capita determines the inflation rate in 46.91 per cent. On the basis of the regression model, if GDP per capita increases by 1 per cent, the inflation rate decreases by

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